This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, click the "Reprints" link at the bottom of any article.

March 8, 2013

4 Ways to Repeat the Mortgage Mess: Peter Wallison

The Fannie and Freddie expert doesn’t think much of an idea currently being floated

Wallison, American Enterprise Institute scholar and former White House counsel under President Ronald Reagan, points to an idea in the mix, one that is “as seductive as it is dangerous:” a private system but with an explicit government mechanism for future bailouts when they prove necessary.

“The rationale?” he writes. “If there's a problem in housing finance, the government will inevitably step in as it did in 2008. So why not create a government insurance program now, compensating taxpayers for the burdens they will have to shoulder eventually anyway?”

This argument, he notes, has been advanced many times since Fannie Mae and Freddie Mac went under, most recently by the Bipartisan Policy Center, a Washington think tank. The plan, released to the public late last month, is already getting some favorable media attention, due to the fact it was written by two former Housing and Urban Development secretaries (Mel Martinez and Henry Cisneros) and two former senators (Democrat George Mitchell and Republican Kit Bond).

“A system for private housing finance with a government insurance backstop may sound reasonable, even sophisticated. But it is seriously flawed.”

First, he argues, such a system cannot logically be contained.

“There is nothing special about housing. Lest we forget, the government also stepped in to rescue the domestic automakers five years ago. Why not a backstop now for Detroit? At the end of this road is bailout nation: a government insurance backstop for every industry.”

Second, taxpayers never get compensated by establishing insurance funds.

“Congress, when it passed the Hurricane Sandy aid bill, bailed out the National Flood Insurance Program to the tune of $9.7 billion. That program had collected insurance over many years to protect against events like Hurricane Sandy—but it wasn't enough.”

He points to other federal insurance systems that have gone or are going broke, including the Federal Housing Administration, the Pension Benefit Guaranty Corp. and the Federal Savings and Loan Insurance Corp.

“To stave off insolvency, the Federal Deposit Insurance Corp. in 2009 ordered banks to pay three years of insurance premiums in advance,” he said.

Congress lacks the incentives of private insurers to charge risk-based rates or to create and maintain the large funds necessary to deal with catastrophic losses, Wallison writes. There is always an incentive to keep rates down to placate interest groups, or to say the fund is large enough—until disaster strikes and the country learns it isn't.

Third, federal insurance encourages careless behavior by those who know that if things go bad, someone will be there with a bailout.

"Consider the Bipartisan Policy Commission's plan, ‘Housing America's Future.’ The government's role would be to backstop a private system of mortgage insurance. The backstop will only come into play if private insurers can't meet their obligations."

The downside? Investors in mortgages or mortgage-backed securities created under the plan would have little incentive to care about the quality of the loans—precisely because they would ultimately be protected from losses by the government, he says.

Fourth, he says, Congress will do what it always does—expand the program so that it covers more and more mortgages of lower and lower quality.

“Since Fannie and Freddie were bailed out, there has been no end of plans to maintain the government's role as guarantor of mortgages for housing and other real estate,” Wallison concludes. “They will all end up putting the country back on the road to another crisis. The only way to ensure a stable mortgage market is to get the government out, and keep it out.”